Using an income-leisure tradeoff model graph, illustrate the income and substitution effects of a wage decrease....

Using an income-leisure tradeoff model graph, illustrate the income and substitution effects of a wage decrease. The income effect dominates the substitution effect. Lable and indicate the effects clearly.

Expert Solution

The income effect of a rise in the hourly wage rate

Positive income effect: When higher wages cause people to want to work more hours in order to reach a target / desired income
Negative income effect: When a target income has been reached and people prefer spending more time on leisure rather than earning more income

The substitution effect of a rise in the hourly wage rate

A rise in the real wage increases the opportunity cost of leisure
Therefore higher wages will always cause people to be incentivised to work longer hours via the substitution effect
But the income effect may work in the opposite direction

Some people may have a backward bending individual labour supply curve – they may choose to work fewer hours when the wage rate rises (ceteris paribus)

Rahul Sunny answered 2 years ago

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